I read an interesting article today on the AAII website by Lee Freeman-Shor, a seasoned portfolio manager based in the U.K. who has a keen interest in the psychology of investing. We share a fascination with the ways that trader personality affects bottom-line results.
To create a diversified money management approach, he hires up to a dozen managers and has carefully studied their trading behavior. He begins the article by making one salient point: the data show that most of the investing ideas/themes thought up and acted upon by his managers prove to be wrong.
Nevertheless, the best managers still manage to turn a handsome profit even when they are right only one-third of the time. How do they do it?
It turns out that there are two useful approaches used by the winning managers when they are losing, and one approach that they share when in a winning trade.
Before we get to that, I’d like to point out the worst possible approach one can take when in a losing position, namely, failing to act and letting small loses become large ones. Freeman-Shor describes this as a “Rabbit” strategy because it is timid and defensive. This behavior arises from not having a plan in regard to losses in the first place. The shock of the unprepared-for loss leads to mental paralysis and small losses thereby swell.
Nevertheless, Freeman-Shor points out that over the long run, most managers do incur a few unavoidable large losses. To counteract them, he believes it is critical for managers to be able to secure at least a few very large gains. Focusing on this possibility is critical when in a winning trade. Find a way to let your winners run and run and run.
Freeman-Shor emphasizes that one should fight the tendency to cut winners short; a very self-limiting habit. In his world, taking frequent 20% gains is a “Raider” strategy that represents premature ejection from a winning trade. His point: taking small profits is a losing tactic in the end.
When in a losing trade, his research indicates that there are two effective tactics. First, cut the loser in a ruthless manner at a reasonable and pre-planned level. Second, start all positions with a small amount of capital and add to the position if prices fall. This averaging-in method only works if one has the native discipline to know when one is wrong. His best managers use both approaches when in a losing trade.
What do you do? When you put on a trade have you planned to lose? If not, losses will come as a shock and may destabilize you, in which case you risk making decisions in a compromised state of mind.
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www.trader-analytics.com (Services for RIAs, banks and hedge funds)